March 22, 2017 - 6:14pm EST by
2017 2018
Price: 38.31 EPS 3.99 4.09
Shares Out. (in M): 147 P/E 9.6 9.4
Market Cap (in $M): 7,022 P/FCF 10.2 10.5
Net Debt (in $M): 2,606 EBIT 794 785
TEV ($): 9,628 TEV/EBIT 9.7 9.8

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Warning: Company has numbers tomorrow morning. They have not had a great track record in the last year or so with reporting, so this may turn out to be the worst-timed writeup in the history of VIC, however wanted to post it as soon as I finished writing.



Next Plc


Company In Numbers






Brief Investment Case


  • Best in class UK retailer with mid to high 20’s ROIC and strong, stable free cash flow

  • Well regarded management team with skin in the game (CEO owns £60m of stock)

  • Difficult macro environment and series of profit warnings has seen share price halve

  • Sentiment has gone from extreme optimism (17x EPS) to extreme pessimism (9.7x)

  • Market too concerned on Retail LfL; predicting doom for Directory after one bad year

  • Business model not broken - stabilisation in next 12-18 months will see multiple recover

  • Supported by strong cash generation (10% FCF yield) and relatively good balance sheet

  • Return of share buybacks should drive EPS recovery and put a floor under the shares

  • Upside to fair value of ~40%


Company In Brief


They are a UK-focused (90% of sales) retailer of clothes and homeware, with clothing being about 85% of sales and homeware about 15%). Sales densities in clothing are slightly higher, so about 75% of retail space is for clothing and 25% for homeware.


Next came into existence in its current guise in the early 80s, with the first Next-branded womenswear store being opened in 1982, and menswear being added a couple of years later. From the mid 1980’s onwards, the pace of expansion quickened and the brand diversified. With the exception of a difficult period in the late 80’s/early 90’s, the space expansion continued at a pretty steady pace until now. I am deliberately glib in describing 20-25 years of the company’s history as “steady expansion” as, by and large, the corporate history has not been particularly exciting, without many large deals or dramatic episodes.


The only really dramatic events would be a near-bankruptcy in the late 80’s, which was as a result of rapid expansion ahead of a dramatic fall in consumer spending after rates were raised. The company had diversified into various diffusion brands, which left the consumer a bit unsure as to what the core offering was, and had taken on quite a lot of financial leverage to drive the expansion. As a macro slowdown coincided with some company-specific issues over brand, disaster nearly ensued. The CEO, George Davies, stepped down, with his deputy, David Jones, stepping into the hot seat. The company was successfully restructured and debt paid down.


Probably the other notable thing in the corporate history would be the accession of Simon Wolfson, the current CEO, into his position in the early 00’s. It was seen as a controversial appointment at the time, as he was only in his early 30’s, and was the son of the then Chairman. Actually people needn’t have worried, and investors have done well under his stewardship. The two key tenets of his strategy have probably been the pursuit of space growth (only at attractive returns), together with the return of excess capital in a shareholder friendly manner.


The quite high long-term growth rate in space has meant that sales densities in the box retail business have been declining since the mid 00’s (as have LfL sales in this part of the business), but in fact the space growth has created economic value, as the company are quite strict in terms of ROIC and cash payback periods for new space. Furthermore, the store network is supportive of the online (they call it Directory) business, as a branch network of >500 stores is quite convenient for click and collect type business (as long as you order stuff online before midnight, you can go and pick it up from the store closest to your work, for free, the next day).


UK Retail Market & Next


According to Planet Retail, The total UK clothing market size was about £58bn in 2015, which compares to total UK retail sales of £358bn and consumer spending of just over £1trn. The womenswear market is about twice the size of menswear, while online was just over 20% of the total.


In terms of competitive environment, depending upon which data one consults, Next is either number 1 of 2 behind M&S, with a share of about 7%-8%, ahead of Primark and Arcadia (5% each). Until a few years ago, the company had steadily taken market share in UK clothing, both as a function of their own space growth as well as key competitor M&S’s long-running issues.



Their market share is down from the peak, which I think is as a result of the overall trend of increased market fragmentation as the rising importance of online has further lowered barriers to entry - in 2006, the top 5 apparel retailers had 38.5% of the UK market; by 2015, the number was down to 31.5%.



The key trend in the industry overall is of course the shift of clothing retail online - in 2011, 11% of UK apparel sales were online; in 2016 the number was 23% - adapting to this change has been the main strategy consideration in recent years.



This trend has shifted the goalposts slightly in terms of the right metrics to use to analyse industry players – whereas 10-15 years ago one would have been mainly focused upon space growth, space density, LfL growth and so on, I think that many would agree that these metrics give a much less complete picture in 2017, and it is now as important to focus on “overall LfL” (so some companies will give you a LfL figure including online sales, which Next does not do), quality of the mobile offering (mobile conversion rates, app ratings, ability to shop omnichannel in a seamless way), and quality of distribution (availability and cost of next day delivery, tightness of delivery slots), to name a few.


Next have a market share of about 4% in homeware, with the leaders being Dunelm and John Lewis with about 7.5% each. Ikea then have about 5%, while Next and Argos have about 4% each.


In their Directory business (the online part of the business, which they report separately), the largest catalogue competitor is Shop Direct (Littlewoods) with 1.8bn of sales; the largest pure play clothing retailer is ASOS with 1.9bn of sales (but 55% of that is outside of the UK), while Amazon is also growing in clothing and homeware.


In terms of what drives overall apparel and homeware demand, the following schematic from a broker is quite helpful in terms of laying out the main drivers.


UK real household disposable income is clearly an important driver, together with consumer confidence (with the two factors of course closely linked).


In terms of the first part, real disposable income, UK real average earnings growth has been quite muted for a number of years. It is currently back into positive territory thanks to a slight uptick in nominal earnings growth, together with falling CPI. Given sterling moves post-Brexit, however, we are already seeing CPI pick up meaningfully, which is expected to accelerate into this year. This is likely to put pressure on disposable incomes, and indeed many of the UK retailers have seen their share prices suffer on the back of this, with Next pointing to tough times ahead:



In terms of consumer confidence, it has held up reasonably well. After a lurch lower post-Brexit, the world continued to rotate on its axis and consumers went back to spending. Without getting into politics, it is perhaps not that surprising that consumer confidence held up okay after Brexit, given that the majority of people got what they wanted.


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One interesting point to note is that with real earnings growing in 2016 and consumer confidence holding up reasonably well post-Brexit, consumer spending also held up quite well, particularly in the back half of the year. Nevertheless, spending on clothing and footwear did not hold up well at all – it is a little bit of a conundrum as to what exactly is happening, but it seems like people are maintaining their spending on “experiences” (i.e. going out, holidays) and cutting back on “things”. This view is validated by the commentary of some of the airlines post-Brexit, with easyjet noting recently that the yearly holiday seems to almost be the “sacred cow” for the UK consumer.


Next Detail


The two key reporting units of the business are Retail and Directory, with Retail being the physical stores, Directory the online business. These two units are £4.1bn of the £4.2bn of group sales, and 780m of the 830m of group EBIT; the 50m discrepancy is their Sourcing business, which is a separate reporting unit tasked with sourcing fabric and making product, from which Next sources about 40% of their overall product. The division has 700m of revenues, all of which represent a group elimination; hence the sales only show in the segment reporting.


Retail revenues are £2.4bn vs. Directory at £1.7bn, but operating income is slightly higher in Directory (£430m vs. £350m in Retail). Product margins are about the same in the two divisions, but Directory benefits from having about 2.5m credit card customers paying ~21% APR on credit balances, which adds about 800bps to the divisional margin after credit costs.


The group generates operating income of about £830m on sales of £4.2bn, which translates to net income of ~£630m and free cash flow of ~£560m on a market cap of £5.7bn and a lease-adjusted EV of ~£7.8bn.


Financial Summary


The medium-term financial performance of the two divisions is summarised below (more detail in later sections)



The strong growth of the Directory business has driven overall group revenue +24% from Jan 10 FY to Jan 17E FY, while the better profitability of that part of the business has meant that operating income has grown 60%; a declining tax rate (UK corporation tax was reduced over the period) meant that net income grew 83%, while steady share buybacks (27% of shares retired over the period) have seen EPS grow ~150%:



In terms of the buybacks, over the last eight years, 91% of the free cash flow has been returned to shareholders via buybacks and special dividends. The split between the two is dependent upon the company's equivalent rate of return calculation.


The ERR calculation they make is to take a notional buyback amount and calculate EPS enhancement from that level of buyback. They then compare that to the return they would need to generate from capex of the same magnitude as the buyback in order to generate equivalent EPS growth. As an example, at the current market cap of £5.7bn, if they were to do a £250m buyback, that would be 4.6% EPS enhancing – 1/ (1 – (.25/5.682)) – 1. Given consensus profit expectations of ~£829m, they would need to add about £829m * 4.6% = £38.2m to generate the same EPS growth in the absence of a buyback. Given a notional £250m buyback, that would mean they would need to generate a return of £38.2m/£250m = 15.3%.


The buyback would thus look attractive to them as they would need to generate a mid teens return (after tax) on an investment to get higher EPS accretion. The company have said in the past that, provided the ERR relative to a buyback does not drop below 8%, they would be buyers of the stock. In “steady state” times, this commitment is obviously supportive to the shares as it sets out a clear level at which the company will be buying stock in the market.


The simplified cash flow statement and drop through of free cash flow to shareholder returns is summarised below:



While shareholder returns have been fairly high relative to FCF in the past, and I expect that to be the case again in the medium-term if they can negotiate the current difficult period, the policy of high shareholder returns has not left the balance sheet in bad shape, with net debt/EBITDA expected to end the year at 0.9x, which would be about 1.7x on a lease-adjusted basis, capitalising the operating leases at 5x the Jan 17 FY rental charges of £230m:



The company is led by Simon Wolfson, who has been CEO since 2001; the shares have risen ~900% over his tenure, an IRR of about 15.3%; he owns about 1% of the company, hence has ~£60m of his own net worth directly aligned with other shareholders.


Despite the current pressures on profits, the company enjoys good margins and exceptional return on invested capital, creating significant value for shareholders. The chart below only includes the recent history, but the overall trend is similar going all the way back to the late 90’s/early 00’s. I estimate that total economic value added by the company over the last 20 years is around £5bn:



In the next sections, I will discuss the main reporting divisions in a little more detail.






It is kind of a misnomer to look at the Retail and Directory businesses in isolation, as there are benefits from them existing together, but I will try to lay out the key characteristics for the sake of clarity, given they do report them separately.


The estate consists of about 540 stores across 8m sq ft. Average store size is about 14,800 sq ft, about 25% above where it was five years ago, while sales densities are down over that same period in the high teens percentage. This is a function of both declining LfL and a weighting towards space growth in homeware, which has lower sales density vis-a-vis clothing.


The Retail business will probably have sales of about £2.3bn in the January 17 full year, with operating income of £402m for a margin of 14.7%. Margins have been as high as 16.7% but will decline in the Jan 17 FY, and again in the Jan 18 full year. Sales are about flat to slightly above where they were a few years ago, however space has grown about 3% pa so the LfL trend has been consistently negative.


The overall strategy in Retail has been to expand space reasonably aggressively with a slight shift in the portfolio away from smaller high street locations to larger, out of town “destination”-type locations – by this I mean that they will combine clothing and home space, sometimes building themselves from scratch, make the locations higher spec (natural light, nicer materials and presentation) so it does not feel as dreary to walk around there, have a Costa franchise on site so that if the wife wants to make a morning of the trip on a Sunday, the husband can at least sit in the coffee shop with a cup of tea and the Sunday papers (apologies for the vague sexism), etc.  One example of many that they give is a new build in Kent, in the south of the UK:



This is another store in Ipswich (south east of the UK, about 30km from where I live, actually), where you can see the coffee shop plonked in the middle of the outlet:



The company have been fairly stringent in terms of the hurdle rates for investment, so in spite of the fairly dire pronouncements from all and sundry on the state of UK non-online retail, these additions to the estate have by and large created value for shareholders. New space has to beat an internal investment hurdle of 15%, with a capital payback of no more than 24 months; over 75% of the stores have profitability above 20%, while 97% is double digit and almost nothing is loss making.


Interpreting these numbers is of course a matter of one’s disposition towards the investment case. Bulls interpret it as the management showing capital discipline, while the bears tend to use it as evidence of the company over earning.


As well as being as aggressive as they can regarding new space, the company have also been fairly proactive on refreshing the footage they already own to keep it from looking tatty and dated, but I think that is probably just a cost of doing business rather than growth capex per se – the following slide from a few years ago gives a rough feel of the split between “growth” and “maintenance”: